How to Avoid "Closet Indexers"

While most mutual fund investors turn to funds that they hope will beat the broader market, a new study shows that a big portion of mutual fund managers are “closet indexers” — that is, they do little to distinguish their funds from passive index funds.

The study, performed by Antti Petajisto, visiting assistant finance professor at New York University’s Stern School of Business, found that about a third of U.S. stock fund assets are managed by “closet indexers”, The Wall Street Journal reports. That means investors in those funds are paying mutual fund expense costs (which average about 1.4% of assets) and getting nothing more than glorified versions of index funds (the expense ratios for real index funds can be less than 0.1%).

One way Petajisto found closet indexers was by looking at the “active share” rate, which measures the percentage of fund assets that are invested differently from a fund’s benchmark, the Journal states. Many funds with active share between 20% and 60% claim to be “actively managed” funds, but are really employing closet indexing, Petajisto contends.

Those who do truly employ an active management approach have tended to fare well, Petajisto found. His study found that in the 20 years ending 2009, the most active stock pickers beat their benchmarks by 1.26 percentage points per year, after fees. On average, funds with lower active share percentages didn’t beat their benchmarks. With correlations among stocks falling after a lengthy period in which equities were marching in something of lockstep, now may be the start of a period in which good stock-pickers can fare particularly well, the Journal hypothesizes.

The Journal says that Morningstar recently examined active-share rates on more than 2,000 U.S. stock funds, and found that managers with the highest active-share rates (those that are most willing to depart from their benchmark’s holdings) tend to focus on just a couple of dozen holdings, and will make big moves into cash when they aren’t finding opportunities in stocks.

The Journal also says that looking at “cross-sectional volatility” — that is, how differently stocks are behaving within a certain market segment — can be a useful tool, telling you when a particular part of the market is offering opportunities, and when its components are behaving more similarly to each other.

Right now, cross-sectional volatility is fairly low, the Journal reports, but areas like U.S. small-cap growth stocks and emerging-market small caps “look like better hunting grounds for active managers”.

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